Welcome to Lesson #7: RRSP or TFSA?
In the past six lessons, all of the examples I gave for the calculation of future portfolio amounts did not take into account any tax implications. This was primarily for the sake of simplicity, but investments in both the RRSP and the TFSA will not have tax implications. For several reasons, I would highly recommend starting to invest through one or both of these account types.
First, what does each acronym stand for? An RRSP is a Registered Retirement Saving Plan, and a TFSA is a Tax-Free Savings Account. Both are provided for by the Canadian government as incentives for Canadians to save, primarily for retirement.
Let me tell you about Betsy..
Betsy is a 24-year-old graphic designer and is employed by
The Awesome Lipstick Company (what a coincidence). She currently earns $38,000 per year but has been taking advanced Photoshop and Web design courses, with the goal of becoming the firm’s Director of Design.
2015 was the first year Betsy earned employment income and so her 2015 RRSP contribution limit is
$6,840. (38,000 x .18 = 6,840).
Betsy has never contributed to a TFSA and so her allowable contribution limit is $41,000:
- 2009: $5,000
- 2010: $4,000
- 2011: $5,000
- 2012: $5,000
- 2013: $5,500
- 2014: $5,500
- 2015: $10,000
Since she started working in February 2014, Betsy has been saving $500/month and now has $10,000 that she is ready to invest.
Which account should she choose?
- Both the RRSP and the TFSA will allow her funds to grow tax-free.
- Contributing $6,840 (the maximum allowable) to her RRSP will reduce her income by the same amount and—assuming a marginal tax rate of 25%—give her a 2015 refund in the amount of $1,710.
- Contributing the entire $10,000 to a TFSA will not provide Betsy with any tax relief for 2015.
So, it’s obvious she should contribute to the RRSP, right?
Not so fast.
Betsy needs to consider that she is young and how her future earnings could change over the next decade. For example, if in the next five years, Betsy’s income grows to $120,000 her marginal tax rate for 2020 could be upwards of 45%.
Assuming at that point, she has $30,000 of unused contribution room in her RRSP, she could split into two contributions 2020 and 2021, of $15,000 each, and, all things being equal her tax refund for each year would be would be $6,750 for a total of $13,500. (15,000 x .45 = 6,750 x 2 = 13,500)
This is getting a bit more complicated than I wanted it be, but my point is that you only get
one chance at an RRSP contribution (it is not a finite amount). Considering this, it can be best to wait to contribute to an RRSP until you are in a high marginal tax rate.
(in Betsy’s case, 45% over 26%)
Pre 2009, this decision had to be weighed against the loss of your early contributions growing tax free—a benefit that cannot be ignored—but with your early funds now able to grow tax free in a TFSA, this issue is somewhat mitigated.
My advice to Betsy (you know, if she was a real person), would be to contribute the entire $10,000 she has for investment in 2015 to a TFSA. As her income grows,
along with her marginal tax rate, she can start adding to an RRSP.
The tax relief you receive from contributing to an RRSP is only
deferred. The rationale being that you contribute at a high marginal rate (i.e. 45%) and then you withdraw (which you are forced to do after age 71), you pay a lower rate (i.e. 26%) because your income is lower in retirement.
But there is no way of knowing at age 24 what your income will be in retirement. It is entirely possible that you will be massively successful, earning $100,000+ year, and thus still paying 45% taxes on your (forced!) RRSP withdrawals.
In comparision the money withdrawn from a TFSA
is not taxed. You already paid tax on the income used to contribute to the TFSA, you did not receive any tax relief on contribution, and so therefore it is not taxed again. Also, you can continue to contribute to a TFSA up until your death (versus the RRSP which again, forces you to not only stop contributing, but to start withdrawing at age 71).
All this to say that in a perfect world, you will max out both your RRSP and TFSA contributions early and often (and at a high marginal tax rate for the RRSP). But since the world is rarely perfect, and if you are not in a high tax rate,
my vote is for the TFSA.
…and that’s it for this lesson!
p.s. In Module #6 of Zero to Portfolio, Opening Your Investment Account, I share my screen and walk you step-by-step through the process of opening an RRSP and a TFSA at Questrade, a leading discount broker in Canada.